Monthly Commentary Sept 2023 – Fixed Income
In the last month, the 10-year Indian government bond
(G-sec) yield went up to 7.25% in the first half and then retraced back to the
previous month’s closing level of 7.17% by the end of the month.
Longer end 20-30 years maturity G-sec yields declined
by 3-5 basis points, while the shorter maturity 1-year G-Sec yield went up by
around 10 basis points from 6.90% to 7.00%.
Market movement during the month was closely linked to
the moves in the US treasury yields. Nevertheless, there were host of other
factors that influenced the bond market ranging from spike in inflation,
reduction of liquidity surplus and demand supply balance.
Global Yields grinding higher
The 10-year US Treasury yields shoot up to 4.33%
during the month before cooling off to close at 4.12% vs 3.96% in the previous
month. The sharp up move in the US treasury yields was attributed to – (1)
stronger than expected employment and growth numbers, and (2) increase in
treasury borrowings.
We expect high interest rates and tightening liquidity
to continue to put downward pressure on the global economic growth and
inflation. We see higher probability of yields coming down than moving higher
from current levels.
Liquidity Conditions Tightened
On August 10, the RBI, in its monetary policy,
introduced the incremental cash reserve ratio (ICRR) of 10% on increase in bank
deposits between May 19, 2023 to July 31, 2023. This was introduced with an
intention to manage the liquidity overhang in the banking system created due to
the withdrawal of Rs. 2,000 denomination notes.
Implementation of the ICRR sucked out Rs. 1.10
trillion from the banking system. During the month, the banking system
liquidity surplus declined from Rs. 2 trillion to Rs. 0.8 trillion. During the
same period, the core liquidity, which excludes the government balance, dropped
from Rs. 3.8 trillion to Rs. 2.5 trillion.
Money market rates also surged higher due to a
reduction in core liquidity. The 3-month Treasury bill was traded around
6.78%–6.80% at the month end. The 3-month AAA PSU commercial paper (CP) and
certificate of deposit (CD) were trading 25–30 bps above the respective
maturity T-Bills.
Transitory Inflation Vs Fiscal Risk
The consumer price inflation spiked to a 15-month high
in July, reaching 7.44% YoY vs. 4.81% in the previous month. This large spike
was primarily driven by food basket. The vegetables contributed to nearly 32%
of CPI inflation. While cereals, pulses, and spices also contributed to the
sequential surge. While ex of food and fuel inflation (Core CPI) moderated to
4.9%.
The central government announced various measures,
like a ban on wheat and non-basmati rice exports, a 40% export duty on onions,
and open market selling of tomatoes, onions, and pulses to control food
inflation. The government also reduced the price of LPG cylinders by additional
Rs. 200 under the PM Ujjwala scheme. These extra-budgetary spendings by the
government along with subdued tax collections, might pose challenge to the government’s
fiscal position.
Going forward, CPI inflation is expected to fall due
to a softening in vegetable prices. Although some vegetable prices, like
tomatoes, have dropped, onion, cereal, and pulse prices have surged, which
keeps inflation elevated above 6% for the next 1-2 months. However, this should
be transitory, and we would expect the headline CPI to fall back to near 5% by
the year's end. We expect CPI inflation to average around 5.3% in FY24.
The risk to the inflation trajectory might emanate
from the deficient rainfall negatively impacting the food production.
Outlook:
We expect the Indian bond yields
to remain in the broader range of 7.0%–7.3% over the coming months, tracking domestic
food prices, crude oil prices and the US treasury yields.
Longer term outlook of bonds
looks more favourable as the rate hiking cycle is near end in most economies
around the world. In most places, a rate cutting cycle might start by early
next year.
Investors with 2-3 years investment horizon and
some appetite for intermittent volatility, can continue to hold or add into
dynamic bond funds.
Dynamic bond funds have flexibility to change the
portfolio positioning as per the evolving market conditions. This makes dynamic
bond funds better suited for the long-term investors in this volatile macro
environment.
Investors with a short-term investment horizon and
with little desire to take risks, should invest in liquid funds which own
government securities and do not invest in private sector companies which carry
lower liquidity and higher risk of capital loss in case of default.
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